PATH Act FIRPTA-Related Changes

Transcription

1 PATH Act FIRPTA-Related Changes International Tax Institute Tuesday, March 15, 2016 Peter J. Genz King & Spalding LLP David A. Levine Office of Associate Chief Counsel International Jason Yen Office of International Tax Counsel _1

2 Background -- Pre-PATH Act Interface Between REITs and FIRPTA 1

3 DC REIT Exception Capital gains recognized by non-u.s. investor on sale of shares of U.S. corporation are exempt from U.S. tax absent FIRPTA. Gain recognized by a foreign person from sale of a U.S. real property interest ( USRPI ), including shares of a U.S. real property holding corporation ( USRPHC ) or former USRPHC, is treated as effectively connected income ( ECI ) under section 897 and subject to FIRPTA tax absent an exception. REITs are generally USRPHCs unless they are mortgage REITs. Gain from sale of REIT shares is therefore subject to FIRPTA tax unless the publicly traded exception in section 897(c)(3) applies or the domestically controlled REIT ( DC REIT ) exception in section 897(h)(2) applies. To qualify as a DC REIT, foreign persons must own, directly or indirectly, less than 50% of value of the REIT s shares throughout a five-year look-back period Section 897(h)(4)(B). Prior to the PATH Act, no statutory constructive ownership rules applied. The PATH Act introduced certain new presumptions and a limited look-through rule (to be discussed). The rationale for the DC REIT exception is shrouded in mystery. 2

4 Section 897(h)(1) -- REIT Distributions A REIT can designate dividends as capital gain dividends to the extent REIT recognizes net capital gain from sale of properties. REIT distributions paid to a nonresident alien or foreign corporation that are attributable to gain from sale of USRPIs are treated as FIRPTA gain -- Section 897(h)(1). A shareholder of a publicly traded REIT that has owned 10% or less (prior to the PATH Act it was 5% or less) of the REIT s shares during the one-year period ending on the date of distribution is not subject to section 897(h)(1) (the Publicly Traded (h)(1) Exception ). Instead, such distributions are treated as ordinary dividends and subject to the regular U.S. dividend withholding regime Section 857(b)(3)(F). Section 897(h)(1) distributions are sometimes referred to herein as FIRPTA distributions. 3

5 Section 897(h)(1) -- Tiered REIT Rule Tiered REIT rule -- capital gain dividends paid by subsidiary REIT to parent REIT retain their FIRPTA taint when paid out as dividends by parent REIT to its non-us shareholders. See Section 897(h)(1) (providing for such treatment with respect to distributions from a qualified investment entity to another qualified investment entity ). 4

6 FIRPTA Withholding on Section 897(h)(1) Distributions Section 1445(e)(6) provides that a REIT must withhold on any portion of a distribution attributable to USRPI gains a tax equal to 35% (or, to the extent provided in regulations, 20%) of such portion. The existing FIRPTA withholding rules applicable to REIT distributions in Treas. Reg have not been amended since this legislative change. The Conference Report accompanying section 1445(e)(6) states that [n]o inference is intended regarding the existing Treasury Regulations in force under section 1445 with respect to REITs. H.R. Conf. Rep. No. 455, 109th Cong., 2d Sess. 503, n. 532 (2006). 5

7 IRS Notice Up until 2007, many tax advisors took the position that section 897(h)(1) applied only to distributions that were or could have been designated as capital gain dividends. REIT liquidating and redemption distributions cannot be designated as capital gain dividends because they are not dividends, even though they can be deducted by REIT under section 562(b). Treas. Reg requires FIRPTA withholding only on distributions that are or could have been designated as capital gain dividends. PLR (Jan. 18, 1990), later revoked by PLR (Sept. 27, 2004), could fairly be read (until it was revoked) as implying that liquidation distributions were not subject to section 897(h)(1). 6

8 IRS Notice IRS Notice announced that the IRS intends to issue regulations (retroactive to the date of the Notice) taking the position that section 897(h)(1) applies to liquidating and redemption distributions as well as capital gain dividends This treatment applies even though liquidating and redemption distributions are not dividends or income, but rather an amount realized for stock under sections 302(a) and 331, and cannot be designated by the REIT as capital gain dividends. This rule applies even if a REIT is a DC REIT and, if the REIT is foreign controlled, even if the foreign investor is a foreign government (a sovereign wealth fund, or SWF ) entitled to the benefit of section 892 on a minority interest stock sale in a USRPHC that otherwise would be taxed under FIRPTA. 7

9 IRS Notice Impact on SWFs The second part of the IRS Notice proclaims that section 892 does not exempt section 897(h)(1) distributions from FIRPTA tax. Real estate capital gains articles of many treaties give US the right to tax gain recognized by home country residents on alienation of real property situated in the United States -- e.g., Article XIII of Canadian treaty. Notice states that capital gains articles of tax treaties give the U.S. the authority to tax section 897(h)(1) distributions and that IRS will issue regulations to make this explicit. 8

10 IRS Notice Compelling arguments can be made that Notice goes beyond Congressional purpose and statutory scheme. Sections 331 and 302 treat a distribution as a sale or exchange by the shareholder. Treas. Reg (e)(3) provides that sections 331 and 302 apply to REITs and their shareholders in determining whether REIT distributions are treated as a payment in exchange for stock. So, if a third party stock sale is exempt from FIRPTA (due to DC REIT exception or section 892), why should a sale of shares back to liquidating REIT be taxed differently? Extensive lobbying efforts with IRS and Treasury to reverse this position have been unsuccessful. The Priority Guidance Plan does not include any guidance under section 897(h)(1). 9

11 IRS Notice In the case of a public REIT liquidation or redemption, Notice does not apply to a shareholder that is entitled to claim the benefit of the Publicly Traded (h)(1) Exception. Further, per Advice Memorandum (Feb. 15, 2008), such amounts are likewise not treated as ordinary dividends under section 857(b)(3)(F). 10

12 Sale of Shares of DC REIT Still Exempt From FIRPTA Tax Notice did not change the tax treatment of gain from a bona fide sale of DC REIT shares; still exempt from FIRPTA tax for all non-us investors. Section 892 still applies to gain recognized on the sale of USRPHC shares for a SWF investor (even as to a USRPHC that is a foreign-controlled REIT) as long as it does not have actual control or effective practical control (directly or through an intervening partnership). 11

13 New Path Act FIRPTA Exceptions Section 897(l), enacted by the PATH Act, creates another FIRPTA exemption for USRPIs held by qualified foreign pension funds and their wholly owned subsidiaries and for REIT distributions they receive. This exception applies to USRPI shares of all current or former USRPHCs, including REITs that so qualify. Section 897(k)(2) creates another exception for certain qualified shareholders of public or private REITs. 12

14 Issues in Structuring REIT Share Sale Buyers typically want to buy assets, not shares -- they are often reluctant to buy shares due to the risk of undisclosed tax liabilities and other contingent liabilities. At a minimum, buyer will want to perform tax due diligence on current and past REIT tax status, may insist on a tax opinion from seller s counsel, and probably will require indemnity. Seller may not want to pay for an opinion and tell buyer to rely solely on diligence and indemnity. Buyer may insist on a price concession to accommodate seller s FIRPTA tax objectives. More difficult to structure a share sale for smaller, non-trophy properties (e.g., multifamily), where buyers and their advisors may be less sophisticated and regard this as an expensive and bewildering deal complication. 13

15 Issues in Structuring REIT Share Sale Buyer will typically want to liquidate the REIT to get a stepped up basis in property without incurring any additional tax. This works as long as buyer is not a corporation and liquidation can be structured as a section 331 liquidation. If buyer is a corporation, must structure to avoid section 332 liquidation. One possibility is to have buyer form a partnership between two of its corporate affiliates which is the purchaser, then liquidate the REIT into the partnership. If buyer is a fund with foreign investors, buyer inherits a builtin section 897(h)(1) issue, which may be a nonstarter ( pass the trash ). 14

16 Seller Concerns in REIT Share Sale Ownership of buyer must allow REIT to continue to qualify as a REIT for that taxable year, which means it must meet the 5 or fewer stock ownership test. Otherwise, seller loses benefit of DC REIT exception, because it only applies to a entity that qualifies as a REIT for the taxable year of the share sale. Seller should negotiate for commitment by buyer not to designate any pre-sale capital gain dividends or ordinary dividends as FIRPTA gain. Some tax advisors believe that buyer should be precluded from liquidating the REIT for some period of time (e.g., until the following taxable year) to avoid the step transaction risk that transaction is recast as an asset sale under a Kimbell- Diamond type theory. Rev. Rul says no Kimbell-Diamond recast where there is a qualified stock purchase, but technically its holding is limited to corporate purchasers. Even if buyer is not a corporation, this should be a non-issue because Kimbell- Diamond applied only to buyer; case law held that the seller still had stock sale treatment (i.e., one-handed clap). A legitimate reason for seller to want buyer to delay a REIT liquidation until following taxable year is to ensure that no property sale gain is recognized in the year of the share sale that could potentially cause any pre-share sale distributions that seller may have received to be treated as FIRPTA gain. 15

17 Foreign Controlled REIT -- Section 892 Exemption Safety in numbers -- Foreign sovereign can form a fund with other foreign sovereigns to acquire 100% (other than accommodation shares) of a foreign-controlled private REIT. This assumes none of the sovereigns qualifies for the new section 897(l) FIRPTA exemption for qualified foreign pension funds. If no single government investor has effective practical control of the fund or the REIT, and the SWF s own controlled entity is structured so that it is not a commercial entity, then REIT dividends are exempt from 30% withholding tax, and gain on sale of REIT shares is exempt under section 892, even though REIT is foreign-controlled (looking through the domestic partnership) and its shares are classified as USRPIs. If REIT does a property sale, however, FIRPTA tax still applies to SWF s share of distribution of sales proceeds (section 897(h)(1), as interpreted by Notice ). 16

18 SWF Club Deal Example 17

19 SWF Club Deal With Multiple Properties Assume SWF wants to invest in a club deal with at least one other SWF and a US fund sponsor. Assume that neither SWF would meet the requirements for the QFP exemption in section 897(l). The deal is that any property exit must be structured as REIT share sale so that section 892 exempts the gain. Each SWF must not have actual control (50% or more of vote or value) or effective practical control of the REIT. Bear in mind that SWF s controlled entity must avoid being classified as a foreign USRPHC to ensure that it is not a commercial entity. This may require that any REIT investment be structured as a DC REIT. Since the deal involves the purchase of multiple properties, one issue is whether you start off with multiple one-off REITs owned by the fund partnership (or a parent REIT that holds the one-off REITs), or a single REIT that owns the entire portfolio in disregarded SPEs. The sponsor may prefer one REIT initially if the intent is to hold for an extended period of time minimize compliance costs, REIT monitoring, and preferred shareholder leakage. Using a single parent REIT also allows income and losses from the various properties to offset, and reduces potential sensitivity to impermissible services and other potential sources of nonqualifying income with respect to a single property. 18

20 SWF Club Deal With Multiple Properties The plan could be to have the parent REIT contribute a particular property to a new baby REIT (which may be effected by filing a check the box election for the SPE vehicle) prior to sale in a transaction intended to be tax-free under section 351, then negotiate a REIT share sale with buyer. To prevent the SPE from simply becoming a qualified REIT subsidiary of the parent REIT, preferred accommodation shares must be issued at the time of the intended baby REIT formation. To qualify as a section 351 exchange, the parent REIT and accommodation shareholders must have section 368(c) control of the baby REIT immediately after the exchange control is broken if there is a binding commitment to sell the shares at the time of the contribution. Parent REIT recognizes FIRPTA gain if the property is contributed subject to liabilities in excess of basis. Section 357(c). 19

21 Taxation of Distributions to SWF from Parent REIT Attributable to Lower-Tier REIT When a foreign-controlled parent REIT sells shares of a subsidiary (baby) REIT, how is the gain characterized for purposes of section 897(h)(1) and the section 892 regulations? Under section 897(h)(1) s tiered-reit rule, USRPI gains recognized by a lower-tier REIT retain their character as such when distributed to an upper-tier REIT and paid out by the upper-tier REIT to its non-u.s. shareholders, even though the upper-tier REIT is a domestic person. The section 892 regulations provide that a foreign government is taxable on gain from the sale of a USRPI described in section 897(c)(1)(A)(i) but is not taxed on gain from the sale of a USRPHC described in section 897(c)(1)(A)(ii) (provided no actual or effective practical control). Treas. Reg T(b), Example (1). Here there is an interesting collision between section 892 and FIRPTA: Following the PATH Act changes to the DC REIT rules, the subsidiary REIT is treated as foreign controlled under the look-through rule of section 897(h)(4)(E)(iii), and thus its shares are a USRPI. However, section 892 ought to trump section 897(h)(1) in this context, because gain recognized by the SWF if it directly owned an interest in the subsidiary REIT would be exempt under section 892 (assuming no actual or effective control). Stated differently, section 897(h)(1) should not cause gain from the sale of the subsidiary REIT s shares to be treated as gain from the sale of a USRPI described in paragraph (i) of section 897(c)(1)(A). 20

22 Step Transaction Risk for Baby REIT Formation If the baby REIT formation occurs in close proximity to the share sale, and the buyer immediately liquidates the baby REIT, there is a risk that IRS will disregard the baby REIT altogether and treat the transaction as an asset sale by Parent REIT to buyer, triggering FIRPTA gain to the SWFs under section 897(h)(1). Step transaction doctrine. West Coast Marketing, 40 T.C. 32 (1966) taxpayer contributed vacant land to a C corporation in a purported section 351 exchange at a time when a price had been agreed to with a buyer (a public corporation) and the buyer s board had approved the transaction. The C corporation was then acquired by the public buyer in a share-for-share exchange roughly six months after formation in a purported tax free B reorganization; the buyer liquidated the target one a half months later. Thus, the target s existence was short-lived Tax Court held that the transaction was in substance a taxable asset sale; it noted that the target corporation only held raw land and was merely a conduit for passing title to the buyer Rev. Rul is similar; IRS ruled that the transaction violated the control immediately after the exchange requirement of section 351 Court Holding case sale of property was negotiated by corporation with buyer; corporation then adopted plan of liquidation and distributed the property to its shareholder, who closed on the sale to buyer Supreme Court held that the sale was in substance made by, and taxed to, the liquidating corporation. 21

23 Issues for Baby REIT Buyer If buyer intends to liquidate the corporation immediately after the sale, the West Coast Marketing risk for seller increases if the baby REIT was recently capitalized. Buyer typically wants to liquidate the REIT quickly in a section 331 liquidation and obtain a basis step-up in the property reflecting the share purchase price. Buyer may be concerned about potential dealer tax in a REIT liquidation since the baby REIT will not have held the property for rent for two years. Delaying the REIT liquidation to reduce any potential dealer risk means that the buyer will recognize gain under section 331 on any postacquisition appreciation in the REIT shares when liquidation occurs. Buyer may ask to perform due diligence on parent REIT as well as baby REIT because of successor rules. 22

24 FIRPTA Changes Made by PATH Act 23

25 PATH Act of 2015 The Brady-sponsored Tax Increase Prevention and Real Estate Investment Act of 2015 (H.R. 34, introduced Dec. 7, 2015) ( TIPREIA ) included a number of FIRPTA changes (see sections 213 and 214) that had been proposed in other bills. These proposals (with only a few word changes), plus a couple of provisions that were part of S. 915, were incorporated into the PATH Act bill released by the House on December 15, 2015 and signed by the President on December 18, It also includes a package of extenders, some non-firpta REIT changes, and a permanent enactment of a 5-year recognition period under section 1374 (which also applies to REITs subject to the built-in gains tax). 24

26 JCT Explanation The Joint Committee explanation of the bill is really not much of an explanation. See Staff of Joint Committee on Taxation, Technical Explanation of the Protecting Americans from Tax Hikes Act of 2015, House Amendment #2 to the Senate Amendment to H.R (Rules Committee Print ), JCX (December 17, 2015) (the JCT Explanation ). It is understood that the Bluebook on the PATH Act is due to be released shortly and may contain additional guidance on the FIRPTA changes. 25

27 Summary of PATH Act FIRPTA Amendments The PATH Act FIRPTA changes include: Changes to the DC REIT rules relating to the determination of domestic control (section 322(b)(1)(A)). A FIRPTA exemption for qualified foreign pension funds and their wholly owned subsidiaries (section 323). An increase in the ownership ceilings from 5% to 10% in the Publicly Traded (c)(3) exception for public REITs only, and a corresponding increase from 5% to 10% for the Publicly Traded (h)(1) exception (section 322(a)(1)). An increase in the FIRPTA withholding rate from 10% to 15%), effective for dispositions after the date which is 60 days after date of enactment (i.e., dispositions after February 16, 2016) (section 324). A repeal of the section 897(c)(1)(B) cleansing exception as applied to REITs (and RICs that are USRPHCs) (section 325). A new, complicated (and seemingly limited in scope) qualified shareholder FIRPTA exemption for REIT investments made by certain foreign public real estate investment trusts and certain foreign partnerships that are publicly traded in the U.S. and hold predominantly U.S. real estate (section 322(a)). The PATH Act also amended section 245(a) to treat dividends received by a foreign corporation from REITSs and RICs as received from corporations that are not domestic persons, for purposes of determining the U.S. source portion of dividends paid by the foreign corporation (section 326). 26

28 Initial PATH Act FIRPTA Regulations A first set of regulations dealing with the FIRPTA changes was issued on February 19, T.D. 9751, 81 Fed. Reg (the PATH Act Regulations ). These regulations are very limited in scope and include changes to the existing regulations to: reflect the repeal of the cleansing rule for USRPHCs that are current or former REITs (Treas. Reg (f)(2(iii)), reflect the increase in the FIRPTA withholding rate from 10% to 15% effective for dispositions and distributions occurring after February 16, 2016 (Treas. Reg (h)), delete the outdated Philadelphia Service Center mailing address for FIRPTA certificates and notices (now they go to the Ogden Service Center), and reflect the exclusion of qualified foreign pension funds and their wholly owned subsidiaries (both as defined under section 897(l)) from the definition of foreign person in Treas. Reg (b)(2)(i)(C). 27

29 PATH Act -- Increase In FIRPTA Ownership Ceilings for Public REITs The PATH Act increased from 5% to 10% the ownership threshold under the publicly traded exception in section 897(c)(3) (the Publicly Traded (c)(3) Exception ), but only as applied to public REITs. Section 897(k)(1)(A). Thus, there is no FIRPTA tax on the sale of public REIT shares by a 10% or less foreign shareholder (taking into account attribution rules). The 5% ownership threshold would continue to apply to sales of shares of publicly traded USRPHCs that are not REITs. The PATH Act also increased from 5% to 10% the ownership threshold under the Publicly Traded (h)(1) Exception applicable to public REITs. Section 897(k)(1)(B). The ordinary dividend withholding tax applies (subject to applicable treaty reduction) in lieu of the FIRPTA tax. Section 857(b)(3)(F). However, consistent with AM (Feb. 15, 2008), a nondividend distribution (such as a redemption) fully escapes U.S. tax. See S. Rep. No , p. 10 (confirming this conclusion). Unfortunately, Notice is not repealed by the PATH Act and IRS and Treasury officials have indicated repeatedly the IRS is sticking by the Notice. 28

30 DC REIT Exception (Before PATH Act) The FIRPTA regs require actual owners of REIT shares, as determined under Treas. Reg , to be taken into account in making DC REIT determination Treas. Reg (c)(2)(i). Treas. Reg refers to the person required to include dividends in income. Tax advisors generally agree that a fund partnership would be looked through to its partners (the persons required to include dividends in income) for purposes of testing DC REIT status. A US C corporation ( USCo ) owned by foreign investors is an actual owner of the REIT shares and generally should be treated as a domestic owner for DC REIT purposes, with no look-through, and the PATH Act changes reinforce this view (as will be discussed). Always desirable for USCo to have other assets and activities to reduce risk of possible sham or section 269 challenge. 29

31 PLR In PLR (Feb. 26, 2009), the outstanding common stock of a private REIT was owned by USCo B and USCo C, both of which were domestic, non-reit C corporations. The common stock of USCo B was owned by a foreign partnership, which in turn was owned, in part, by a publicly traded foreign corporation ( Public ForCo ). The preferred stock of USCo B was owned by USCo C. The direct and indirect owners of the common stock of USCo B were apparently all foreign persons. All of the shares of USCo C were owned by a wholly owned foreign subsidiary of Public ForCo. 30

32 PLR In the proposed transaction, USCo C proposed to sell some of its common REIT shares to a fund partnership that would have domestic and foreign investors. The taxpayer represented that USCo B and USCo C would own more than 50% of the value of the REIT s outstanding shares after the transaction. The ruling also states that USCo B and USCo C are USRPHCs for FIRPTA purposes and that neither of the C corporations had elected to be taxed as a REIT or RIC and was not otherwise a conduit (or some form of lookthrough entity). The IRS ruled that actual owners of the REIT common shares were USCo B and USCo C because they were the persons required to include the REIT dividends in income. Thus, they constituted "good" domestic ownership for purposes of testing DC REIT status. In other words, the IRS adhered to the actual owner rule and did not look through the USCos to their foreign shareholders. 31

33 Is a Parent REIT Looked Through When Testing a Subsidiary REIT s DC REIT Status? Before the PATH Act amendments, it was not clear if directly or indirectly meant that a look-through rule applies when parent REIT owns shares of subsidiary REIT. Parent REIT is a domestic person and is technically the actual owner of the subsidiary REIT shares that includes the subsidiary REIT dividends in income. How does a public REIT know who its foreign shareholders are? What if the public REIT has a known foreign shareholder component that is large? A private parent REIT was more problematic because the ultimate share ownership facts were generally (but not always) known. But if parent REIT was a pre-existing, bona fide REIT with multiple investors and held other properties besides the shares of the subsidiary REIT, a look-though approach arguably was inappropriate. If a REIT fund was an open-end fund, controlling its future non-u.s. investor base was a bigger issue. Will the fund commit that it will not allow foreign ownership percentage to go beyond X%? In the absence of guidance, under pre-path Act law tax advisors generally were reluctant to opine on a subsidiary REIT s status as a DC REIT where the parent REIT was substantially or wholly owned by non-u.s. persons and a look-through approach would have caused the subsidiary REIT to be foreign controlled. This issue may not matter to a foreign shareholder of the parent REIT that is eligible for section 892 exemption with respect to the parent REIT. 32

34 PATH Act DC REIT Provisions The DC REIT changes in the PATH Act are identical to those included in H.R and S S. Rep. No , p. 12 (accompanying S. 915, which had similar DC REIT provisions) states in the Reasons for Change section that uncertainty [as to whether a REIT is domestically controlled] might affect foreign investment in such entities. The problematic directly or indirectly language in the DC REIT ownership test is unchanged, but specific rules are added to section 897(h)(4)(B) (the provision that defines a DC REIT) for purposes of determining the holder of stock. Section 897(h)(4)(E). Any shareholder holding less than 5% of a publicly traded REIT s traded class of shares at all times during the testing period is treated as a United States person unless the public REIT has actual knowledge to the contrary. Section 897(h)(4)(E)(i). Shareholders owning 5% or more will have to be diligenced if their ownership is significant and the public REIT wants to be certain about its DC REIT status. 33

35 PATH Act DC REIT Provisions Any stock of a REIT that is held by a publicly traded REIT (or a RIC that issues redeemable securities) is treated as held by a foreign person, unless the parent entity itself is domestically controlled (after applying the new rules), in which case the parent is treated as a U.S. shareholder of the lower-tier REIT. Section 897(h)(4)(E)(ii). This rule is particularly important for non-u.s. investors who invest in a private REIT jointly with a public REIT, and the non-u.s. investor wants the private REIT to qualify as a DC REIT. 34

36 PATH Act DC REIT Provisions Any stock of a subsidiary REIT held by a private parent REIT or RIC is treated as held by a U.S. person in proportion to the stock of the parent REIT or RIC that is held by (or treated as held by under one of the new rules) a U.S. person. Note that the look-through provision says held by, but does not repeat the general directly or indirectly test of ownership. Section 897(h)(4)(E)(iii). In other words, a private REIT parent is looked through and its domestic and foreign shareholders are treated as owning a proportionate interest in a lower-tier REIT. Example: Publicly traded REIT owns 40% of private REIT 1. The other 60% is owned by foreign persons. Private REIT 1 owns 70% of private REIT 2, and the other 30% is directly owned by U.S. persons. Assume public REIT is treated as a domestic shareholder in its entirety under the section 897(h)(4)(E)(i) presumption. Thus, the public REIT is treated as a U.S. person that owns 28% (40% x 70%) of private REIT 2. This indirect U.S. ownership coupled with the direct domestic ownership puts the total U.S. ownership of private REIT 2 at 58%, and it qualifies as a DC REIT. Assume instead that private REIT 1 is held 80% by non-u.s. persons and 20% by U.S. persons. This means that 56% (80% x 70%) of the stock of private REIT 2 is owned by foreign persons. It does not qualify as a DC REIT. 35

37 PATH Act DC REIT Provisions This puts the nail in the coffin on the argument that a subsidiary REIT can qualify as a DC REIT if it is owned by a privately held parent REIT (a domestic person), even if the parent REIT is wholly owned by foreign persons. Congress once again passed on the opportunity to adopt explicit constructive ownership rules for purposes of the DC REIT test. The only exception is the express look-through rule for a private REIT or RIC shareholder of a lower-tier REIT. Directly or indirectly is still the rule of the day. Tax advisors will continue to assume that domestic partnerships are looked through under the indirectly aspect of the test and the fact that the partners, rather than the partnership, are required to pay tax on REIT dividends received by the partnership. 36

38 PATH Act DC REIT Provisions The express look-through rule for private REITs can be seen as further support for the view that a C corporation shareholder of a REIT is not looked through, as the IRS ruled in PLR (Feb. 26, 2009). This private ruling was also cited in the discussion of existing law regarding the domestically controlled test in S. Rep. No , 114 th Cong., 1 st Sess. at 6 (2015), which accompanied S It should be stressed that, in contrast to public DC REITs that are treated (under the presumption) as entirely domestic owners of lower-tier REITs, a private REIT parent is NOT treated as a domestic owner of a subsidiary REIT (even if the parent private REIT is a DC REIT). Instead, the parent private REIT is looked through to the persons that hold its shares. The DC REIT amendments are effective on the date of enactment. PATH Act Section 322(c)(2). S. 915 would have amended section 897(h)(4)(B) to provide that a REIT would not be treated as a DC REIT for any period unless the entity makes a disclosure of such status on its annual report or, if it does not file an annual report, on its website. This was not included in the PATH Act. 37

39 PATH Act Repeals Cleansing Exception for REITs Section 325 of the PATH Act repeals the cleansing exception in section 897(c)(1)(B) for REITs (and for RICs that are USRPHCs). This change was not included in TIPREIA and was added in the House- Senate negotiations. It has never made any sense for the cleansing rule to apply to a REIT, although it literally does; this may have been an oversight by Congress in

40 PATH Act QFP Exemption The PATH Act adds new section 897(l) to provide a FIRPTA exemption for qualified foreign pension funds ( QFPs ) and any entity wholly owned by a QFP. Before getting to the details, it is useful to review the tax treatment under current law of a foreign pension fund that invests in U.S. real estate without a REIT structure (either directly or through a partnership). 39

41 Background -- U.S. Taxation of a Foreign Pension Entity Foreign corporations and nonresident alien individuals engaged in a U.S. trade or business are taxed at the regular graduated rates on income effectively connected with such trade or business, less deductions properly allocated thereto ( ECI ). Sections 882(a)(1) and 871(b)(1). A non-u.s. person is deemed to be engaged in the trade or business conducted by any partnership or trust of which it is a partner or beneficiary. Section 875. The term nonresident alien individual includes a foreign trust. Reg (a) (such term includes a nonresident alien fiduciary); section 7701(a)(6) (defining fiduciary). Section 641(b) provides that for purposes of determining the taxable income and the tax liability of a foreign trust, the trust is treated as a nonresident alien individual that is not present in the U.S. at any time. However, this rule expressly does not apply to domestic pension trusts. Reg (a)-0(a). Thus, this rule may be limited to family foreign trusts. 40

42 Background -- U.S. Taxation of a Foreign Pension Entity The U.S. tax classification of a foreign pension entity is far from clear. There is some authority suggesting that it can be classified as an ordinary trust, depending on its form of organization, rather than a business entity whose tax status would depend on the default and election rules under the check-the-box regulations. See PLR (June 11, 1999) (foreign pension trust classified as an ordinary trust under Reg (a)); PLR (Nov. 5, 2007) (foreign entity organized to provide superannuation benefits to its members under applicable foreign law classified as an ordinary trust under Reg (a)). If a foreign pension is classified as a trust, it is entitled to the 20% capital gains rate on effectively connected capital gains. Section 871(b)(1); section 1(h). Do the subchapter J rules apply? If the QFP has ECI, are the employee beneficiaries treated as engaged in a U.S. trade or business under section 875? 41

43 Background U.S. Taxation of Directly Held U.S. Real Estate Investments Rents from real property are FDAP income and subject to 30% withholding (subject to treaty reduction) unless treated as ECI. If the operation of U.S. rental real estate is a trade or business, then gain from the sale of the property is also ECI. Section 864(c)(2). Further section 861(a)(5) provides that such gain is U.S. source (this provision was enacted pre-firpta and the PATH Act did not change it). Taxpayer can also make a Code (or applicable treaty) net basis election to treat income and gain from U.S. real property as ECI. Sections 871(d) and 882(d). 42

44 Background U.S. Taxation of Directly Held U.S. Real Estate Investments For cases in which rental real estate was held to be a trade or business, see Pinchot v. Commissioner, 113 F.2d 718, 719 (2d Cir. 1940) (nonresident alien owned a number of parcels of improved land and managed them through an agent; court held that the taxpayer was engaged in business in the United States at the time of her death within the meaning of a provision of U.S. federal estate tax law because the management activities, which included maintaining the properties, were considerable, regular and continuous); Lewenhaupt v. Commissioner, 20 T.C. 151 (1953), aff'd per curiam, 221 F. 2d 227 (9th Cir. 1955); Herbert v. Commissioner, 30 T.C. 26 (1958), acq., C.B. 6; De Amodio v. Commissioner, 34 T.C. 894 (1960), aff'd, 229 F.2d 623 (3d Cir. 1962). 43

45 Background U.S. Taxation of Directly Held U.S. Real Estate Investments There is also authority holding that net leased real property is not a trade or business. See, e.g., Neill v. Commissioner, 46 B.T.A. 197 (1942) (nonresident alien taxpayer leased unimproved real property to a tenant who built a building thereon and occupied it; lease was a long-term lease that required tenant to pay insurance and property taxes and maintain the property; taxpayer retained a U.S. law firm to collect the rents and make payments on the related mortgage; held, taxpayer was subject to gross basis withholding tax on the rents and could not offset the rents with interest expense deductions because the taxpayer s activities did not rise to the level of a trade or business); See also Rev. Rul , C.B. 226 (holding that a nonresident alien was not engaged in a trade or business within the meaning of section 871(b)(1) merely by reason of leasing rental properties in the United States where the individual s activities were limited to the supervision of the negotiation of new leases; the IRS viewed this as not beyond the scope of mere ownership of real property or the mere receipt of income from real property since such activity was sporadic rather than continuous (that is, a day-to-day activity), irregular rather than regular, and minimal rather than considerable ). 44

46 How Did Enactment of FIRPTA in 1980 Change Things? The enactment of section 897 in 1980 simply plugged what was then considered as ECI loopholes. By taxing all gain or loss from the sale of USRPIs as ECI, the statute ensured that gain from the sale of passive investment property, e.g., vacant land or residential property, would be taxed as ECI and not escape U.S. tax. FIRPTA also made gain or loss from the sale of stock of a current or former U.S. real property holding corporation ( URRPHC ) taxable as ECI; previously a non-u.s. investor could sell the shares of such a corporation free of U.S. tax, and the buyer (under then-existing corporate tax law, which was repealed in 1986) could generally liquidate the C corporation and get a basis step-up without incurring a corporate-level tax. FIRPTA also enacted two special rules for REITs: (i) the DC REIT exception to the foregoing USRPHC rule and (ii) section 897(h)(1), which treats distributions attributable to gain from the sale a REIT s USRPIs as ECI. FIRPTA also closed certain other loopholes, such as the use of installment sales of U.S. real property to avoid U.S. tax by deferring gain recognition to taxable years when the non-u.s. investor was no longer in a U.S. trade or business. Section 864(c)(6) and (c)(7). FIRPTA also overrode nonrecognition provisions of the Code in certain cases. 45

47 Taxation of Ordinary REIT Dividends Received by Foreign Pension Trust The withholding rate on ordinary REIT dividends paid to foreign pension funds is often reduced to zero under tax treaties (e.g., Canadian, UK, Dutch treaties), provided the foreign pension fund is not related to the REIT. The Canadian and Dutch treaties limit this zero rate to amounts received from unrelated parties; the Dutch treaty uses an 80% test for this purpose. 46

48 PATH Act Qualified Foreign Pension Fund Exemption From FIRPTA Section 323 of the PATH Act adds section 897(l), which provides that section 897 does not apply to any USRPI held directly (or indirectly through 1 or more partnerships) by a qualified foreign pension fund ( QFP ). Section 897(l)(1)(A). The exception also applies to USRPIs held by any entity all of the interests of which are held by a qualified foreign pension fund. Section 897(l)(1)(B). The exemption also applies to any distributions received by a QFP from a REIT. (TIPREIA did not include this language; the PATH Act clarification eliminates what would have been a nagging uncertainty as to whether section 897(h)(1) gain is attributable to USRPIs held by a QFP.) 47

49 QFP Exemption Effective Date and Reg Authority Section 897(l) applies to dispositions and distributions after date of enactment. See Section 323(c) of the PATH Act. The Secretary is given the authority to issue such regulations as are necessary or appropriate to carry out the purposes of the provision. Section 897(l)(3). The Preamble to the PATH Act Regulations requests comments regarding regulations to be issued pursuant to section 897(l)(3). 48

50 Background -- Administration s Proposal to Exempt Foreign Pension Funds From FIRPTA The Administration s General Explanations of the Fiscal Year 2015 Revenue Proposals, Department of Treasury, p. 138 (March 2014), described the foreign pension fund FIRPTA proposal as follows: The proposal would exempt from the application of FIRPTA gains of foreign pension funds from the disposition of U.S. real property interests. For this purpose, a foreign pension fund would generally mean a trust, corporation, or other organization or arrangement that is created or organized outside of the United States; generally exempt from income tax in the jurisdiction in which it is created or organized; and substantially all of the activity of which is to administer or provide pension or retirement benefits. The Secretary would be granted authority to issue regulations necessary to carry out the purposes of the proposal, including whether for this purpose an entity or arrangement is a foreign pension fund or a benefit is a pension or retirement benefit. 49

51 Background Administration s Proposal to Exempt Foreign Pension Funds From FIRPTA The Joint Committee s explanation of the qualified foreign pension fund provision included in the Administration s Fiscal Year 2014 budget proposals contains some interesting commentary on the Administration s foreign pension fund proposal. See Staff of Joint Committee on Taxation, Description of Certain Revenue Proposals Contained in the President s Fiscal Year 2014 Budget Proposal, JCS-4-13 (December 2013) (the JCT 2014 Budget Explanation ). 50

52 Alleged Purpose of QFP Exemption: Level the Playing Field With U.S. Pension Funds The intent of the provision is to treat foreign pension funds that invest in U.S. real estate comparably to U.S. pension trusts that are exempt from tax. JCT 2014 Budget Explanation, p. 95. It certainly does not create parity, however. First, the PATH Act left intact the ECI regime that pre-dated FIRPTA, which means that income and gain from directly held U.S. rental real estate investments are generally taxed as ECI, irrespective of FIRPTA or the PATH Act. U.S. pension funds, on the other hand, generally are not taxed on directly held U.S. rental real estate operating income and sale gain. On the other side of the coin, a QFP is entitled to the section 897(l) FIRPTA exemption even if it would be subject to UBTI tax if it were a domestic pension fund. UBTI could result, for example, if a pension fund leveraged its investment in a USRPHC s shares or because it invested in a REIT that was a pension-held REIT and part of the REIT dividends were taxed as UBTI. 51

53 Definition of QFP A qualified foreign pension fund means any trust, corporation, organization or other arrangement if: Created or organized under the laws of a foreign country. Established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (or persons designated by such employees) of one or more employers in consideration for services rendered. No single participant or beneficiary has a right to more than 5% of its assets or income. Subject to government regulation and provides annual information reporting about beneficiaries to the foreign country s tax authorities. Under the laws of the country in which it is established or operated, either: contributions to the entity that otherwise would be subject to tax under local law are deductible or excluded from the gross income of such entity or taxed at a reduced rate, or taxation of investment income of the entity is deferred or taxed at a reduced rate. 52

54 Are Foreign Sovereign Pension Plans Covered? The JCT 2014 Budget Explanation (pp )discusses the administration s proposal in some detail and suggests possible refinements and modifications. It does not comment on governmental pensions, nor does it give any specific reason why they should not be within the scope of the provision. The purpose of the provision was to put foreign pension funds on a parity with domestic pension funds. State pension plans are major players in the U.S. real estate market and they are generally exempt from U.S. tax on their real estate income. It seems illogical that the parity policy objective could have only been intended to apply to private foreign pension plans. 53

55 JCT 2014 Budget Explanation The JCT 2014 Budget Explanation suggests that the scope of the proposal might be defined by analogy to the categories of foreign pension funds described in the FATCA regulations, although it cautions that the objective of FATCA, which is transparency of U.S. ownership, is not necessarily the same as the foreign pension fund FIRPTA exemption, and hence the exceptions under FATCA might be too broad or too narrow (depending on the FIRPTA policy to be achieved). The FATCA statute does not specifically address foreign pension funds, but does authorize regulations providing for exemptions for certain tax-exempts and any other class of persons identified by the Secretary as posing a low risk of tax evasion. Section 1471(f)(4). The final FATCA regulations identify six categories of foreign pension funds presenting a low risk of tax evasion and therefore deserving of exemption. 54

56 FATCA Exemption for Foreign Sovereigns Treas. Reg (a) provides that the term exempt beneficial owner includes any foreign government, any political subdivision of any foreign government, or any wholly owned agency or instrumentality of any one or more of the foregoing. Treas. Reg (b) further defines this term to mean (solely for purposes of this regulation) the integral parts, controlled entities and political subdivisions of a foreign sovereign. Such regulation does not specifically refer to the section 892 regulations definition of a separately organized governmental pension trust. 55

57 QFP Definition Similar to FATCA Broad Participation Retirement Plan Definition The QFP definition is similar in certain respects to the definition of a broad participation retirement fund ( BPRF ) in the FATCA regulations. See Treas. Reg (f). Such regulation defines a BPRF as a fund established to provide retirement, disability, or death benefits, or any combination thereof, to beneficiaries that are current or former employees (or persons designated by such employees) of one or more employers in consideration for services rendered, provided that the fund Does not have a single beneficiary with a right to more than five percent of the fund's assets; Is subject to government regulation and provides annual information reporting about its beneficiaries to the relevant tax authorities in the country in which the fund is established or operates; and Satisfies one or more of four conditions relating to the source of its assets, contributions, and timing of distributions. One of these conditions is that the fund is generally exempt from tax on investment income under the laws of the country in which it is established or operates due to its status as a retirement or pension plan. 56

58 Does QFP Exemption Apply to Foreign Government Plans? A foreign government pension fund that benefits governmental employees presumably also can qualify as a QFP if it meets these tests. Some government plans are not organized as a separate legal entity; they may be described in terminology similar to a fund. Because section 897(l) (2) includes an arrangement, the existence of a separate legal entity should not be a precondition. What about foreign sovereign social security-type systems? These are typically funded through taxes imposed on employer and/or employee. Query whether the in consideration for services requirement is met if funding is through governmental levy but benefits are not limited to employees of the sovereign or its agencies. In the broad sense, of course, any government benefits from having its citizens gainfully employed. Compare Treas. Reg T(c)(1)(i), which defines a separately organized pension trust that is a controlled entity of a foreign sovereign as one that is established exclusively for the benefit of employees or former employees of a foreign government, or for the benefit of such persons as well as current or former nongovernmental employees that perform governmental or social services. What about foreign pension funds whose home country has no tax system (middle east)? 57

59 What About Disability and Death Benefits? What if the plan also provides for other benefits, such as disability benefits or insurance benefits? Presumably this will not adversely affect the exemption if the primary purpose of the plan is to provide retirement or pension benefits; the statute does not say the plan must exclusively provide retirement or pension benefits. Compare Treas. Reg T(c)(1)(iii), which defines a separately organized pension trust that qualifies as a controlled entity of a foreign sovereign as one that provides retirement, disability, or death benefits in consideration of services rendered, and Treas. Reg (f)(2), which defines a broad participation retirement fund and states that it must be a fund established to provide retirement, disability, or death benefits, or any combination thereof. 58

60 QFP Definition Similar to FATCA Broad Participation Retirement Plan Definition The first requirement for a BPRF is identical to the first requirement in section 897(l)(2)(B), except that the BPRF refers to retirement, disability, or death benefits, or any combination thereof while section 897(l)(2)(B) refers only to retirement or pension benefits. It seems unlikely that the addition of the word pension was intended to cover something not subsumed by retirement. The fact that disability or death benefits appear in the BRPF definition but not in section 897(l)(2)(B) could support a conclusion that plans established solely to provide disability or death benefits do not qualify for the FIRPTA exemption, but it does not necessarily mean that a plan established to provide both retirement benefits and disability or death benefits does not qualify. 59

61 Entity Owned by Multiple QFPs Section 897(l) applies not only to USRPIs held directly a QFP, but also to USRPIs held by any entity all of the interests of which are held by a [QFP] (a QFP Subsidiary ). Section 897(l)(1)(B). This rule is written in the singular. Not surprisingly, the PATH Act Regulations do not depart from or expand upon this statutory language. See Treas. Reg (b)(2)(i)(C). Suppose a foreign corporation or trust is owned by multiple foreign pension trusts, each of which is a QFP? The JCT Explanation refers to a foreign entity wholly-owned by a qualified foreign pension fund. JCT Explanation, p Suppose a QFP Subsidiary is indirectly wholly owned by a QFP through intermediate tier entities? 60